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Subject:  Corporate Bond Investing: A Reading List Date:  5/7/2013  1:14 AM
Author:  globalist2013 Number:  34892 of 35593

Reading lists are the embodiment of an opinion. Someone, hopefully someone informed on the subject and cognizant of his audience's needs, suggests that such and such books would be worth reading. Invariably, because he loves his subject, the list is too long by half, no matter its intended briefness. That's just the nature of recommendations. Ask someone where might be a good place to go vacationing, and do so in the presence of bystanders, and you'll hear of more places than you could possibly visit in a lifetime. So let me put some constraints on what my list is intended to accomplish, and to whom it might be directed.

No one needs to buy their own corporate bonds. It is perfectly possible to build portfolios without them, and some very successful investors have done so. Peter Lynch comes to mind as being someone who avoided bonds entirely, arguing that their function of “providing income” could be done better in other ways, such as selling off shares of stock (as losers happened or profits needed harvesting). That's the first point to be made: bond investing is a choice, not a necessity, and, as a choice, there are a lot of ways of doing it, none of which necessarily involve corporate bonds.

Second point: By convention, corporate bonds are divided into investment-grade and speculative-grade. A typical, 60/40, balanced portfolio of stocks and bonds won't include any speculative-grade bonds, even though Modern Portfolio Theory will argue that as much as a 16% allocation of the whole portfolio, not just the fixed-income portion, should be spec-grade bonds, aka “high-yields”, also known "junk bonds”. The reason for the recommendation is simple. High-yields offer a chance for asset-class diversification, hence an opportunity to manage risk, all the while enhancing returns. But high-yields as an asset-class are a fairly recent invention.

Also, the intended function of bonds within a balanced portfolio has to be considered. Typically, when stocks are doing well, bonds aren't, and vice versa. Bonds are seen as being a means of obtaining stability. A friend, who got into stock investing early and who was used to holding only stocks, says that one day he had the good fortune to meet one of the true “old-timers”, a retired guy who would meet up with his buddies at local broker's office and then hang out, watching the ticker tape and occasionally making a trade. John says they got to talking about what stocks they each owned, and he was surprised to learn that this obviously-committed, obviously-successful stock investor also held a large position in bonds. John asked him why. “Why?”, said the tiny, little man, drawing himself erect, eyes flashing, “Because when the whole world goes to hell, and from time to time it does, I can clip my coupons, and I know I'll survive.” John says he never forgot that comment, and he began to include bonds in his portfolio.

If high-yields are a recent invention, what about “fallen angels”, the once formerly well-regarded debt of major companies that have now fallen on hard times? Technically speaking, investing in fallen angels is what is termed 'special situations' investing, or 'deep value' investing, or 'vulture investing'. It's a specialization that is generally put off-limits when constructing balanced portfolios. Hence, it tends to get ignored by most investors, both because they already have a sufficient menu of asset-classes from which to build their portfolio, and because of the reputation for high risk that the asset-class carries.

Now enter Michael Milken. Building on the earlier work of Hickman, Milken ran numbers on many years of bond returns and bond defaults and concluded that the asset-classes offered an unearned premium of approximately 2%/year that everyone was ignoring, because speculative bonds had such a bad reputation. (Subsequent studies, time and again, confirm the persistence of that premium.) Sometime later, entered humble me, who hated risk, so much so that his preferred investment vehicle was a CD. “Why”, he asked, should I buy some, no-earnings tech stock that everyone is chasing when this fallen-angel of a real company, with real earnings, and real equipment and assets that could be liquidated to pay off the bond holders, is offering a fat yield on its bonds? Like, many multiples of what I get from CD's? Maybe junk bonds are like CD's for grownups. I'll lose some positions, but as long as my losses are smaller than my gains, I'll come out ahead.”

Obviously, a more careful statement of that reasoning process would go like this: If, on average and over the long haul, reward is proportional to risk, but there is a persistent unearned premium that can be shown to exist in the asset-class of high yields, might that premium be enough to overcome the inevitable friction a beginner would have to pay by attempting to break into the asset-class? Furthermore, if junk weren't the whole of the portfolio, but merely a judicious part of an all-bond portfolio that would still include CD's and such, might not such an investor put together an investment vehicle that had the equivalent reward/reward profile of a traditional, balanced portfolio? In other words, though adding junk bonds to an otherwise all-bond portfolio would require accepting equity-like risks, it might also offer equity-like returns.

So, that's I got into the business, though the back door of CD's. And that's why I view corporate bonds as a continuum, not as separable asset-classes. Although I do have to admit that awareness, as an explicit awareness, is a recent discovery. It was what I was doing in practice without really realizing it.

OK, having set the stage by all those preceding remarks, I can now identify my target audience. Myself, of course. The following reading list is a reading list for me. It's a list of books, heavily underlined, I can pull off my shelves and say, “If I had to pick just ten books that a beginning corporate bond investor ought to read, or that someone already doing it ought to constantly review, these would be the books.”

#1 Getting Started in Bonds, by Sharon Saltzgiver Wright
Any edition, and any other of the other beginner's books, could be substituted. The purpose of this book is to introduce subject-specific vocabulary and basic, fixed-income concepts. But her presentation is charming, and her insights are shrewd. If reading Saltzgiver opens a world you didn't know existed, and you want to learn more, then continue on below to Crescenzi and Barnhill. Otherwise, stop here. Congratulate yourself for having gotten this far and switch over to other things. Bond investing wasn't meant for everyone.

#2 The Strategic Bond Investor, by Anthony Crescenzi
This is the only bond book I'm aware of that can be seen as building on what is offered in the beginning books without crossing over the line to become unreadably “professional”. His strength is in showing how macro-economics plays out in the bond market. If you're a stock investor, he's talking your language. If you want to stop here, this, too, would be a good place.

#3 High-Yield Bonds: Market Structure, Portfolio Management, and Credit Risk Modeling, by Theodore M. Barnhill, Jr, et al.
If you've gotten this far, you're a bond nerd, and you'll love this book. Also, what they say about high-yields is exactly what any investment-grade investor also needs to know. The book is no less readable than the previous two. Whether it is more useful than Crescenzi's will depend on what sort of bond investor you want to become.

I said I'd list ten books, but those three are as much as you'll ever need to read about bonds. The rest of the list deals with other things. In no special order, you also need the following;

#4 An intro to 'Modern Portfolio Theory'. My favorite (despite is awful and misleading title) is The Prudent Investor's Guide to Beating Wall Street at Its Own Game, by John J. Bowen. Understanding Asset Allocation, by Victor Canto is another possibility. And some people will like William Bernstein's or John Bogle's rehashes (but they shouldn’t, because both are ignorant, innumerate idiots who don't understand basic probability theory.)

#5 Then, having been convinced that the task of managing risk and reward is easy and predictable, simple and assured, you need to read any of Nassim Talib's books or technical papers or just Beniot Mandelbrot's, The MisBehavior of Markets: A Fractal View of Risk, Ruin and Reward. Either will show you, in non-mathematical ways, why trusting Modern Portfolio Theory will get you into trouble and why, sooner or later, trusting it will lose you more money than you could ever have anticipated,

#6 You need also a sense of how markets work and to learn a bit of the history of investing. Two good choices are Edwin Lefevre's, Reminiscences of a Stock Operator, or Justin Mamis', The Nature of Risk. Pick one and then get back to the other at a later time.

#7 In order to avoid companies whose risks outweigh the fat yields promised by their bonds, you need to be able to read financial statements. Martin Fridson's, Financial Statement Analysis is a readable intro and cynically shrewd:

“Corporations have substantial incentives to exploit the fact that accounting principles are neither fixed for all time nor so precise as to be open to only one interpretation.... From this point of view, the best kind of financial statement is not one that represents the company's fin